Page "Arbitrage" Paragraph 30

In the 1980s, risk arbitrage was common.

In this form of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events.

The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid ; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price — if the merger goes through as predicted.

Traditionally, arbitrage transactions in the securities markets involve high speed, high volume and low risk.

At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists ( that is, before the other arbitrageurs act ).

When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage.

One way of reducing the risk is through the illegal use of inside information, and in fact risk arbitrage with regard to leveraged buyouts was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken and Ivan Boesky.